ACCOUNTING MANUAL

FOR DEPARTMENTS

CHAPTER 13
Leases

Issued December 2019

 Chapter 13: Leases

Chapter Content
1 Overview ....................................................................................................................................... 3
2 Key Learning Objectives ............................................................................................................... 3
3 Scope ............................................................................................................................................ 4
4 Identification of a Lease ................................................................................................................ 4
5 Classification of Leases ................................................................................................................ 5
5.1 General ............................................................................................................................... 5
5.2 Classification at Inception ................................................................................................... 5
5.3 Risks and rewards of ownership......................................................................................... 6
5.4 Classification Indicators ...................................................................................................... 7
5.5 Discussion on Specific Issues .......................................................................................... 10
5.5.1 Land and buildings ............................................................................................... 10
5.5.2 Leased vehicles ................................................................................................... 11
5.5.3 Cell phones and 3G modems .............................................................................. 11
6 Recognition, Measurement and Recording ................................................................................ 11
6.1 Finance lease in the financial statements of lessee ......................................................... 11
6.2 Finance lease in the financial statements of lessor .......................................................... 13
6.3 Operating lease in the financial statements of lessee ...................................................... 14
6.4 Operating lease in the financial statements of lessor ....................................................... 15
7 Sale and Leaseback ................................................................................................................... 16
8 Disclosure ................................................................................................................................... 17
9 Summary of Key Principles ......................................................................................................... 18
9.1 Identification...................................................................................................................... 18
9.2 Classification..................................................................................................................... 18
9.3 Recognition and measurement ......................................................................................... 18
9.4 Recording and measurement ........................................................................................... 18
ANNEXURE 1: Examples for Leases ................................................................................................... 20

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 Chapter 13: Leases

1 Overview
The purpose of this Chapter is to provide guidance on distinguishing between an operating and finance
lease and to illustrate the consequential accounting requirements applicable to departments.
The Office of the Accountant-General has compiled a Modified Cash Standard (MCS) and this manual
serves as an application guide to the MCS which should be used by departments in the preparation of
their financial statements.

Any reference to a “Chapter” in this document refers to the relevant chapter in the MCS and / or the
corresponding chapter of the Accounting Manual.

Explanation of images used in the manual:

Definition

Take note

Management process and decision making

Example

2 Key Learning Objectives

• Understanding the different types of leases

• Understand the accounting and disclosure requirements for each type of lease from the lessee’s
and lessor’s perspective

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3 Scope
A department applies this Chapter in distinguishing between operating and finance leases for purposes
of classifying recognised lease expenditure in the primary financial information, and for providing
additional disclosures about leases in the secondary financial information.

4 Identification of a Lease

A lease is an agreement whereby the lessor conveys to the lessee in return for a
payment or series of payments the right to use an asset for an agreed period of time.

As is apparent from the definition above, leases are agreements whereby a department can gain the
use of an asset or grant the use of an asset for a specified period of time. A typical example would be
a straightforward rental agreement; however, departments also use a lease to finance an asset without
having to purchase the asset outright.
It is important to note that, in most cases, legal ownership of the leased asset will rest with the lessor,
while the possession and use of the leased asset will vest in the lessee.
Two scenarios can exist:
• legal title may not transfer, but control might; and
• legal title may well transfer at the end of the agreement.
Most leases are easily identifiable based on the terms and conditions of the lease agreement. However,
in some instances, entities may enter into agreements that do not take the legal form of a lease, but
that conveys the right to use an asset in return for a series of payments. These arrangements may
comprise of one transaction, or a series of transactions, which in substance may be a lease or may
contain a lease element.
A lease may for example be one element in a broader set of agreements with private sector entities to
construct, own, operate and/or transfer assets in terms of a Public Private Partnership (PPP).
Departments often enter into such agreements, particularly in relation to long-lived physical assets and
infrastructure assets. For example, a department may construct an office building. It may then lease
the office building to a private sector entity as part of an arrangement whereby the private sector entity
agrees to:
• lease the office building for an extended period of time (with or without an option to purchase the
facility);
• manage the office building and its facilities within; and
• fulfil extensive maintenance requirements.
If the arrangement contains a lease, the requirements of the Chapter on Leases will be applied to the
lease element and therefore the lease will need to be classified as either a finance lease or an operating
lease, based on the classification criteria as indicated in the Section on Classification Indicators
below.
Departments may also enter into a variety of agreements for the provision of goods and/or services,
which necessarily involve the use of dedicated assets (such as computer equipment). In some of these
agreements, it may not be clear whether or not a lease, as defined by this Chapter, has arisen, for
example a department can enter into a hiring arrangement to hire furniture for a month or for a specific
event.
The identification of leases may require professional judgment to be exercised. If the agreement
contains a lease, it must be accounted for as a lease in terms of the requirements of the MCS.

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For the purposes of recording leases, a department should maintain a lease register that will enable it
to comply with the disclosure note requirements of the MCS.

5 Classification of Leases
[MCS Chapter 13.04 – 13.13]

5.1 General
Once it has been determined that an arrangement is (or contains) a lease, it should be determined
whether the lease should be classified as either a finance or an operating lease. This classification
results in substantially different accounting treatments and classification of the payments made for the
use of the asset.
There are instances where the terms lease and rent agreement are used interchangeably. The
difference between a lease and rental agreement is the duration. A rental agreement tends to cover a
short term, from hours to a few months, while a lease contract is applied to long periods, say about 12
months or longer. This difference should not be applied rigidly as it is common practice for contracts to
be termed rental agreements. This does not mean that they are excluded from being leases. One still
needs to go through the conditions of the contract to determine if it is a lease and if so, whether it is a
finance lease or an operating lease.

A finance lease is a lease that transfers substantially all the risks and rewards
incidental to ownership of an asset. Title may or may not eventually be transferred.
An operating lease is a lease other than a finance lease.

In terms of SCOA, finance lease transactions should be funded from the

department’s capital budget, whereas payments in terms of operating lease
agreements are funded from the current (operating) budget of the department.
Also, in terms of SCOA, a transaction that involves a once-off payment for the
temporary use of a capital asset which is owned by an external party is expensed to
Rental and Hiring and not to operating or finance lease payments as leases involve
a series of payments.

5.2 Classification at Inception

As the classification of a lease agreement depends on the definitions in the MCS, the circumstances
surrounding the lease agreement may be different for the parties to the agreement; as a result, the
classification of the same lease may be different in the accounting records of the lessee and lessor.
The classification of the lease is made at inception of the lease and is not changed, unless both
parties agree to change the provisions of the initial lease (other than by renewing it), and these changes
would have resulted in a different classification of the lease at its inception. This amended lease is
considered a new lease agreement.

Note the difference between commencement date and inception date:

The commencement date is the date from which the lessee is entitled to exercise
its right to use the asset.
The inception date is the earlier of the date of the lease agreement and the date of
commitment by the parties to the principle provisions of the lease. This is also when
the lease should be classified as either a finance lease or an operating lease.

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The distinction between the two is extremely important for accounting purposes as
described below:
• Classification of the lease i.e. whether it is a finance lease or an operating lease
is done at the inception of the lease and not at commencement;
• The amounts to be recorded takes place at the commencement of the lease and
not the inception of the lease; and
• Recognition (of lease payments) begins at or after the commencement of the
lease and not the inception of the lease.

In the case of a renewal or extension of the lease, where the lease arrangement was reassessed, the
accounting for the lease should be applied from the inception of the renewal or extension period.

5.3 Risks and rewards of ownership

The classification of a lease does not depend on where the legal ownership of the leased asset lies, but
rather on the extent to which the risks and rewards incidental to ownership of the asset have been
transferred from the lessor to the lessee. If substantially all of the risks and rewards have been
transferred to the lessee, it is a finance lease; otherwise it is an operating lease.
The risks and rewards that are considered to be incidental to ownership include (but are not limited to)
the following:

Risks
• Which party carries the risk of possible losses as
a result of idle capacity, technological
obsolescence and fluctuation of asset value as
a result of change in economic conditions?
• Which party carries the risk of repairs and
maintenance of the asset?
• Which party carries the risk of insurance cost /
losses?
Rewards
• Deriving revenue or service potential from the
use of the asset over its economic life;
• Profitable operation of an asset over its
economic life; and
• Gain from the increase in value or the realisation
of the residual value upon disposal.

Transactions and other events should be accounted for and presented in accordance
with their substance and financial reality and not merely with legal form. Thus, legal
title of a leased asset may not necessary transfer to a lessee, but the lessee acquires
the economic benefits or service potential of the use of the leased asset for the major
part of its economic life, therefore such arrangement should be accounted for as a
finance lease in accordance with the requirements of the MCS.

Lessor Lessee
Finance Treat as a Asset Treat as a
lease Sale Purchase

Operating Lessor Right to use the Lessee

lease Asset

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These indicators are intended to assist as a guide in the decision-making process,

but may not be conclusive. A department should therefore not follow the guidance
blindly, but it is important that it considers the overall substance of the lease
agreement for each of its leases. The classification should be based on an overall
assessment of whether substantially all of the risks and rewards of ownership of the
leased asset have been transferred to the lessee.

5.4 Classification Indicators

A department should consider the terms of the agreement or contract and should classify the lease
depending on the substance of the transaction rather than the form of the contract. This requires a
department to carefully assess the classification of a lease.
The following are examples of situations that will normally result in a lease being classified as a finance
lease:

These indicators are intended to assist as a guide in the decision-making process,

but may not be conclusive. A department should therefore not follow the guidance
blindly, but it is important that it considers the overall substance of the lease
agreement for each of its leases. The classification should be based on an overall
assessment of whether substantially all of the risks and rewards of ownership of the
leased asset have been transferred to the lessee.

• Ownership of the asset is transferred to the lessee when the lease term ends;
• The lessee has an option to purchase the asset at a price that is expected to be much lower than
the fair value of the asset at the date the option becomes exercisable and at the time of entering
the lease, it is expected that the lessee will exercise the option;

The exercise of the option is based on the expectation of the department. Therefore,
if the department does not expect to exercise the option (for example, if the
department has a policy of returning all leased assets at the end of the lease term,
regardless of the price), this indicator will not be present - even if the price at the date
that the option is expected to be exercised is significantly lower than the fair value.

• The lease term is for a major part of the economic life of the asset even though title is not
transferred;

The lease term is the non-cancellable period for which the lessee has contracted
to lease the asset together with any further terms for which the lessee has the option
to continue to lease the asset, with or without further payment, when at the inception
of the lease it is reasonably certain that the lessee will exercise the option.
If the lease agreement contains a cancellation clause which states that the lessee will
have to compensate the lessor with an amount equal to what would have been paid
if the lease was not cancelled, then the cancellation clause is ignored in determining
the lease term. This is because 100% of the lease payments will still be made.

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Difference between economic life and useful life

Economic life is either:
• the period over which an asset is expected to be economically usable by one or
more users; or
• the number of production or similar units expected to be obtained from the asset
by one or more users.
Useful life is either:
• the period over which an asset is expected to be available for use by a
department; or
• the number of production or similar units expected to be obtained from the asset
by a department.
Economic life is therefore the total expected life of an asset and useful life is the
expected life of the asset over which the department will use it. The useful life will
therefore never be more than the economic life, but can be the same.

There is no clear-cut threshold as to what will be considered to be ‘a major part of

the economic life of the asset’, although approximately 75% is considered reasonable
in terms of common practice.
A department should follow its own process to determine the acceptable threshold
that it will use in making the assessment. This threshold should be documented in
its own operational policies. It should be noted, however, that this threshold should
not represent an automatic cut-off point - a department should consider all relevant
factors when assessing the classification of a lease to decide whether substantially
all of the risks and rewards have been transferred.
It should be noted that a department will need to determine the economic life and the
useful life of the leased asset, in order to determine whether the asset qualifies as a
finance lease or not.

Example: Classification of leases

Department B leases a vehicle, with a total economic life of 5 years from Ecorental
Company for a period of 4 years. 4 out of 5 years is the useful life and a major part
of the 5-year economic life of the vehicle. Therefore, the lease could be classified as
a finance lease at the inception of the agreement.

• At the inception of the lease the present value of the minimum lease payments amounts to at least
substantially all of the fair value of the leased asset;

The minimum lease payments are the payments over the lease term that the lessee
is or can be required to make, excluding contingent rent, costs for services and
taxes to be paid by and reimbursed to the lessor, together with any amounts
guaranteed by the lessee or by a party related to the lessee.

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There is no clear-cut threshold to what amounts to ‘at least substantially all of the fair
value’ of the asset when comparing this value to the present value of the minimum
lease payments, although approximately 90% is considered reasonable in terms of
common practice.
A department should follow its own process to determine the acceptable threshold
that it will use in making the assessment. This threshold should be documented in its
own operational policies. It should be noted, however, that this threshold should not
represent an automatic cut-off point - a department should consider all relevant
factors when assessing the classification of a lease to decide whether substantially
all of the risks and rewards have been transferred.
It should be noted that a department will need to determine the present value of the
minimum lease payments and the fair value of the leased asset, in order to determine
whether the leased asset qualifies as a finance lease or not. If the fair value is not
available, the asset will be accounted for at the present value of the minimum lease
payments.

Example: Calculating the present value of minimum lease payments due

Department A entered into a lease agreement on 1 April 2010 to lease a machine for
a period of three years. The monthly lease payment is R5,000 payable in arrears
beginning 30 April 2010 and the rate implicit in the lease is 5%.
The present value of the minimum lease payments will be calculated as follows:
PMT 5,000 Note the lease is
payable on a monthly
i 0.00416667% (5% / 12) basis, therefore the
n 36 (3 x 12) interest rate and period
also need to be
PV? 166,828 monthly.

This calculation can be done on a financial calculator or in MS Excel.

• The leased asset is of such a specialised nature that only the lessee can use it without major
modifications; or
• The leased asset is not easily replaceable by another asset.
The following are other indicators of situations that individually or in combination could also lead to a
lease being classified as a finance lease (the secondary indicators listed in the MCS):
• If the lessee can cancel the lease, the lessee will carry any loss that will be incurred by the lessor
as a result of the cancellation;
• Gains or losses due to changes in the fair value of the residual value are credited to the lessee (for
example in the form of a rent rebate equalling most of the sales proceeds at the end of the lease);
and
• At the end of the initial lease, the lessee has an option to extend the lease at a rent that is
substantially lower than the market rent.

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Example: Classification of leases

Department B leases a vehicle, with a total economic life of 5 years, from Ecorental
Company, for a period of 4 years. Department B has the option to continue with the
lease for another year, without payment during this period. It is reasonably certain
that Department B will exercise this option.
There are two indicators that this lease agreement is a finance lease:
• Department B has the ability to continue with lease for another year at a rent
lower than market rent; and
• The lease term will be five years in total, which is equivalent to the economic life
of the vehicle.
This lease will therefore be classified as a finance lease at the inception of the
agreement

For a lease to be classified as a finance lease it is not necessary to have all the above indicators present,
it could be one or a combination of the above indicators.

It is important to note that the indicators mentioned under this section are not always
conclusive. A lease can be classified as an operating lease even if one or more of
these indicators are present, if it is clear from other factors that the risks and rewards
of ownership are not transferred to the lessee.
The deciding factor is the extent to which risks and rewards incidental to ownership
of an asset lie with either the lessor or lessee.
Generally, a finance lease is economically similar to a purchase of the underlying
asset.

The interest rate implicit in the lease is the discount rate that, at the inception of
the lease, causes the aggregate present value of:
• the minimum lease payments; and
• the unguaranteed residual value;
to be equal to the sum of:
• the fair value of the leased asset; and
• any initial direct costs of the lessor.

5.5 Discussion on Specific Issues

5.5.1 Land and buildings

When a lease contains both a land and a building element, the two components should be assessed
individually. Land usually has an indefinite economic life, which implies that the land will normally be
classified as an operating lease. It is therefore possible that the rental of the building may be classified
as a finance lease and the rental of the land as an operating lease.
On initial recognition, where the land and building is classified as an operating lease and a finance lease
respectively, the lease payments should be allocated between the land and the building based on the
fair values of each. If payments cannot be allocated, the entire lease is classified as finance lease,
unless the lease contract is clearly an operating lease, e.g. where the building is leased for a significant
shorter period than its economic life.

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In instances where the lease payment amount that would be allocated to land is immaterial, both the
land and building can be treated as a single asset for classification purposes and the economic life of
the asset would be based on the economic life of the building.

Sound cash management includes avoiding prepayments for goods or services (i.e. payments in
advance of the receipt of the goods or services), unless required by the contractual arrangements with
the supplier. For example, rental agreements may require rent to be payable monthly in advance. If a
department makes monthly payments in advance, over a period of twelve months of the financial year
there will be 12 payments made. Therefore, in a modified cash environment department are advised
not to raise a prepayment where the amount prepaid is judged to immaterial. It is expected that should
there be an increase in rent in March for the April rent, the increase will not be significant to result in a
material misstatement.

In instances where in terms of the contractual arrangement the department is expected to pay for a
period more than a month, for example pay two months in advance, then the department should
consider materiality when raising a prepayment.

5.5.2 Leased vehicles

When a department leases vehicles from the relevant government garage, the lease is either classified
as an operating or a finance lease. Careful consideration should be exercised in deciding whether the
leases are operating or finance leases.

6 Recognition, Measurement and Recording

6.1 Finance lease in the financial statements of lessee

[MCS Chapter 13.14 – 13.21]

The events and transactions pertaining to the lease agreement are recognised and recorded as follows:

Transfer of
Inception of Commencement of Payment of Year-end ownership (where
the lease the lease instalment(s) applicable)

The lease is Asset is received The payment(s) is The total future Record the asset
classified as either and recorded in recognised as lease commitment in the
a finance or the lease register capital expenditure is disclosed in the departmental
operating lease of the department notes to the AFS asset register and
corresponding
note
Any unpaid
instalment due by
31 March
disclosed as a
payable in AFS

If at the end of the lease term department takes ownership of the asset(s), it should measure the finance
lease asset(s) acquired at:
• cost, being the fair value of the leased asset or; if lower,
• the sum of the minimum lease payments made, including any payments to be made to acquire
ownership at the end of the lease term, excluding interest.

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The present value of the future minimum lease payments is discounted at the interest rate implicit in
the lease, which can usually be calculated from the information provided in the contract. If it is not
possible to calculate the rate implicit in the lease, then the department can use a reasonable proxy rate
such as the prime lending rate at inception of the lease.
The future minimum lease payments expected to be made should be recorded in the notes to the
financial statements as secondary financial information in the following periods:
• not later than one year;
• later than one year and not later than five years; and
• later than five years.

All finance lease payments made by a lessee are classified as expenditure for
capital assets in the statement of financial performance, and as cash flows on
investing activities in the cash flow statement.

Example: Calculating the present value of minimum lease payments due

Department A entered into a lease agreement on 1 April 2010 to lease a machine for
a period of 3 years. The monthly lease payment is R5,000 payable in arrears
beginning 30 April 2010 and the rate implicit in the lease is 5%.
The present value of the minimum lease payments will be calculated as follows:

PMT 5,000 Note the lease is

payable on a monthly
i 0.00416667% (5% / 12) basis, therefore the
n 36 (3 x 12) interest rate and
period also need to be
PV? 166,828 monthly

This calculation can be done on a financial calculator or in MS Excel.

Example: Calculating the “take-on value” of a leased asset

Department A entered into a lease agreement on 1 April 2010 to lease a machine for
a period of 3 years. The monthly lease payment is R5,000 payable in arrears
beginning 30 April 2010 and the rate implicit in the lease is 5%. The department will
take ownership of the asset at the end of the lease term.
The present value of the minimum lease payments is R166,828 and the fair value of
the asset on 31 March 2013 is R130,000.
The take-on value for the asset is thus R130,000.

The initial direct costs that the lessee incurs to negotiate and arrange a lease should be added to the
amount recognised as an asset.
Contingent rents expected, i.e. payments linked to a variable that is not known until payment is due, for
example, rentals linked to an inflation index, rentals based on the sales the lessee achieves from the
leased premises, and usage-based rentals (such as leases of copier equipment in which the lease
payments are fixed with an additional amount due for each copy made over a contractually specified

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number). As such, these portions of the lease payments are expensed in the period payment is made
and excluded from the minimum lease payments.

6.2 Finance lease in the financial statements of lessor

[MCS Chapter 13.24 - 13.26]

The events and transactions pertaining to the lease agreement are recognised and recorded as follows:

Transfer of
Inception of Commencement of Receipt of Year-end ownership (where
the lease the lease instalment(s) applicable)

The lease is Asset delivered to The receipt(s) is The total future Remove the
classified as either the lessee and the recognised as lease receivable is asset from
a finance or lease register is revenue disclosed in the departmental
operating lease updated notes to the AFS asset register
and
corresponding
Any instalment note
due by 31 March
disclosed as
receivable for dept
revenue

Where the department leases out an asset it should continue to be accounted for in accordance with
Chapter 11 on Capital Assets. The leased asset should be recorded in the lease register of the lessor
for the duration of the lease. If ownership of the leased asset is transferred to the lessee at the end of
the lease term, the asset will be removed from the lease register on expiry of the lease and should be
added to the asset register.
The actual lease payments received during the financial year should be recognised and measured as
revenue in the statement of financial performance in accordance with Chapter 7 on Revenue.
The amount of lease revenue that is expected to be received should be recorded in the notes to the
financial statements as secondary financial information in the following periods:
• not later than one year;
• later than one year and not later than five years; and
• later than five years.

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6.3 Operating lease in the financial statements of lessee

The events and transactions pertaining to the lease agreement are recognised and recorded as follows:

End of lease
Inception of Commencement of Payment of Year-end
the lease the lease instalment(s)

The lease is Asset is received The payment(s) is The total future Asset is
classified as either and recorded in recognised as lease commitment returned to
a finance or the lease register current is disclosed in the the lessor
operating lease of the department expenditure notes to the AFS

Any unpaid
instalment due by
31 March
disclosed as a
payable in AFS

The lease payments under an operating lease should be recognised as current expenditure in the
statement of financial performance in accordance with Chapter 8 on Expenditure.
The lease commitment for future operating lease expenditure should be recorded in the notes to the
financial statements as secondary financial information. This is the future minimum lease payments at
financial year end, showing separately those payable:
• not later than one year;
• later than one year and not later than five years; and
• later than five years.

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6.4 Operating lease in the financial statements of lessor

The events and transactions pertaining to the lease agreement are recognised and recorded as follows:

End of lease
Inception of Commencement of Receipt of Year-end
the lease the lease instalment(s)

The lease is Asset delivered to The receipt(s) is The total future Asset is
classified as either the lessee and the recognised as lease receivable is received
a finance or lease register is revenue disclosed in the back from
operating lease updated notes to the AFS lessee

Any instalment
due by 31 March
disclosed as
receivable for dept
revenue

Where the department leases out an asset; the underlying asset should continue to be accounted for
in accordance with Chapter 11 on Capital Assets.
The actual lease payments received during the financial year should be recognised and measured as
revenue in the statement of financial performance in accordance with Chapter 7 on Revenue.
The amount of lease revenue that is expected to be received should be recorded in the notes to the
financial statements as secondary financial information in the following periods:
• not later than one year;
• later than one year and not later than five years; and
• later than five years.

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7 Sale and Leaseback

[MCS Chapter 13.29 – 13.34]
Sometimes a department will enter into a transaction involving selling an asset and then the leasing
back of the same asset from the purchaser - the department is then the lessee.
The opposite can also happen where the department acquires an asset and leases that same asset
back to another party - the department is then the lessor. The sales price and lease payments are inter-
linked as they are usually negotiated at the same time.
The table below shows how the lessee and lessor will account for a sale and leaseback transaction:

Sales proceeds Capital asset leased Lease payments / Disclosure

receipts
Lessee Recognised as Remove the asset from Recognise as capital The disclosure
revenue in accordance the asset register on expense in requirements for
with Chapter 7 on the date of sale. accordance with lessees apply equally
Revenue. Account for the asset Chapter 8 on to sale and leaseback
at the end of the lease Expenditure. transactions.
if ownership transfers Where the department
back to the lessee. is given a reduction in
the lease payments
instead of actual cash
from the sale of the
asset, it should disclose
this fact in the notes to
the financial
statements.
Lessor Not applicable Record and disclose Account for the lease The disclosure
the asset acquired in revenue in requirements for
accordance with accordance with lessors apply equally to
Chapter 11 on Capital Chapter 7 on sale and leaseback
Assets. Revenue. transactions.
Remove the asset from
the department’s asset
register if ownership of
the leased asset is
transferred to the
lessee at the end of the
lease term.

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8 Disclosure
Refer to the Specimen Annual Financial Statements for the illustrated disclosure requirements.

The MCS Chapter on Leases requires a department to furnish details of each lease
agreement. There are instances where departments have numerous lease
agreements. In such instances, the department can group the lease disclosure
narrative according to the sub-categories of assets leased. For example, if a
department has 100 photocopiers with escalation clauses ranging from 1% to 5%
they may specify the escalation clause as follows:

“The escalation clauses of the 100 photocopiers leased by the department range from
1% to 5%.”

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9 Summary of Key Principles

This chapter prescribes the criteria for distinguishing between operating and finance leases, and
prescribes the disclosure requirements for leases from both the lessor’s and the lessee’s perspectives.

9.1 Identification
A lease is an agreement between two parties whereby the one party (the lessor) allows the other
party (the lessee) to use its assets for an agreed period of time in return for a payment or series of
payments.
A department has to assess whether an arrangement entered into with another party may constitute
a lease or may contain in substance a lease element.

9.2 Classification
OPERATING LEASE FINANCE LEASE
Definition Lease other than a finance lease Transfers substantially all the risks
and rewards incidental to
ownership

9.3 Recognition and measurement

OPERATING LEASE FINANCE LEASE
LESSEE LESSOR LESSEE LESSOR
• Operating lease • Operating lease • Finance lease • Finance lease
payments are receipts are payments are receipts are
recognised as recognised as recognised as recognised as
current revenue in expenditure for revenue in
expenditure in accordance with capital assets in accordance with
accordance with Chapter 7 on accordance with Chapter 7 on
Chapter 8 on Revenue. Chapter 8 on Revenue.
Expenditure. Expenditure.
• All interest paid is
allocated to the
“finance lease”
account, the
separation of the
interest portion was
discontinued from 1
April 2012.

9.4 Recording and measurement

OPERATING LEASE FINANCE LEASE
LESSEE LESSOR LESSEE LESSOR
• A lease asset is not • The asset is • The leased asset is • The asset is
recorded in respect continued to be measured and continued to be
of an operating accounted for in recorded as an accounted for in
lease, as the risks accordance with asset in the notes accordance with
and rewards Chapter 11 on to the financial Chapter 11 on
incidental to Capital Assets. statements in Capital Assets.
ownership is not accordance with
• If ownership of the this Chapter and • If ownership of the
transferred to the leased asset leased asset
lessee. Chapter 11 on
transfers to the Capital Assets at transfers to the
• The lease lessee at the end lessee at the end of
commitment for the end of the lease
of the lease term, if ownership the lease term, the
future finance lease the asset is asset is removed

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 Chapter 13: Leases

expenditure is removed from the transfers to the from the asset

recorded in the asset register on lessee. register on expiry of
notes to the expiry of the • The lease the lease.
financial statements lease. commitment for • The amount of
in accordance with • The amount of future finance lease lease revenue that
this Chapter. lease revenue that expenditure is is expected to be
is expected to be recorded in the received is recorded
received is notes to the in the notes to the
recorded in the financial statements financial statements
notes to the in accordance with in accordance with
financial this Chapter. this Chapter.
statements in • No need to disclose
accordance with separately the
this Chapter. interest portion.
• However, for a
finance lease in a
PPP the interest
must still be shown
separately in the
notes to the
financial
statements.

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 Chapter 13: Leases

ANNEXURE 1: Examples for Leases

A1.1 Example: Determining the classification of a lease
A department has entered into a 4-year rental agreement for a photocopier. In terms of the agreement,
the department will have the right to use the photocopier for the rental period, there after the photocopier
must be returned to the lessor.
The following are the main provisions of the agreement:
• The rental payment is R2,800 per month over a period of 48 months.
• The rental payments will fluctuate in accordance with changes in the prime lending rate.
• The department is responsible for the insurance of the asset, subject to conditions/restrictions
imposed by the Treasury Regulations.
• The agreement states that ownership remains with the lessor, and at no time will ownership pass
to the department.
• At the end of the lease term, the lease can continue on a month-to-month basis (based on the final
rental amount), until notified by either party.
• If the department cancels the agreement during the term, it has to immediately pay all outstanding
payments for the remainder of the rental period to the lessor.
If the department was to purchase the photocopier outright, a cash payment of R110,000 will be
required. The rate implicit in the lease is 12%. The economic life of a photocopier is considered to be 5
years

The department applies the lease indicators to the provisions in the lease agreement to determine
whether it should be classified as an operating or a finance lease:

Standard example of situations that normally indicate Application to rental Met

finance leases agreement (Y/N)
The lease transfers ownership of the asset to the lessee by the No such provision in agreement N
end of the lease term
The lessee has the option to purchase the asset at a price which No such provision in agreement N
is expected to be sufficiently lower than the fair value at the date
the option becomes exercisable for it to be reasonably certain, at
the inception of the lease, that the option will be exercised
The lease term is for the major part of the economic life of the Lease contract is for 4 years Y
asset even if title is not transferred and the economic life of the
photocopier is 5 years
4/5 = 80%
This is considered to be a major
part of the life of the asset
At the inception of the lease the present value of the minimum Using a financial calculator or Y
lease payments amounts to at least substantially all of the fair MS Excel:
value of the leased asset PV = (rate,nper,pmt)
PV = (12%/12,48,-2,800)
Note the lease is payable on a monthly
basis, therefore the interest rate and PV = 106,327
period also need to be monthly Therefore, the present value
equals substantially all of the
fair value of R110,000

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 Chapter 13: Leases

The leased assets are of a such a specialised nature that only The photocopier is not N
the lessee can use them without major modifications specialised and can be used by
other entities
The leased assets cannot easily be replaced by another asset Photocopier can easily be N
replaced by another
If the lessee can cancel the lease, the lessor’s losses associated Department has to pay all Y
with the cancellation are borne by the lessee outstanding rentals if it cancels
the lease
Gains or losses from the fluctuation in the fair value of the Not applicable to agreement N
residual accrue to the lessee (for example, in the form of a rent
rebate equalling most of the sales proceeds at the end of the
lease)
The lessee has the ability to continue the lease for a secondary Not applicable, as the N
period at a rent that is substantially lower than market rent department can continue renting
the photocopier at the final
rental amount
It is not necessary that all criteria are met for an agreement to constitute a finance lease. If substantially
all the risks and rewards of ownership have been transferred to the department, it should account for
the agreement as a finance lease. The transfer of risks and rewards is demonstrated by the fact that
the present value of the minimum lease payments equals substantially all of the fair value of the
photocopier, that the lease is for the major part of the economic life of the asset and that the department
is responsible for insuring the asset.
The department should therefore classify the lease as a finance lease and account for it accordingly.
The fact that the department can continue to lease the asset, after the lease period has expired, on a
month-to-month basis, means that the department will have to reclassify the arrangement once the
option has been exercised (i.e. at the end of the rental period), because as from then on, the lease
period cannot be calculated as there is no fixed rental period. Therefore, lease classification changes
from a finance lease to a month-to-month operating lease.
A1.2 Commitments involving leases
There may be instances where one department enters into leases on behalf another department.
Each contracting department must record the arrangement either as a lessee or a lessor.
For example, assume there is a contract between Department A and Department B. Department B
requires that Department A sources accommodation for Department B. Department A enters into a
contract with Service Provider Z to lease a building on behalf of Department B. Department B is required
to pay Department A for accommodation and Department A pays Service Provider Z for Department
B’s accommodation and claims the accommodation costs incurred from Department B.

pays pays

Department B Department A Service Provider Z

(Lessee) (Lessor)
Provides Provides
accommodation
accommodation

In the leases context, a commitment irrevocably binds the department to incur future expenditure for
lease services that are still to be received.
Department A has a contract with Service Provider Z. However, they will not incur expenditure as costs
incurred are recovered from Department B.

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Department B will record the lease commitment for future expenditure in line with the arrangement with
Department

A1.3 Expired leases

Scenario 1: The lease has expired yet the department still occupies the building. The process of
renewing the lease has begun and it is expected that the new lease period will be three years. Previous
practice indicates that renewal of the lease will materialise.
This is a lease commitment as a legitimate expectation of contract renewal has been created at year
end. The total future lease commitment for three years is recorded by the contracting department in the
lease commitment note.
Scenario 2: The lease has expired yet the department still occupies the building. The process of
renewing the lease has not begun. The lease thus continues on a month to month basis. Although
there may be past practice of continued occupation, a lease commitment can’t arise prior to
management deciding to continue to occupy the building as management may choose not to occupy
the building and incur the resulting future expenditure thereon. Thus, no lease commitment, as defined,
exists. In such instances the department is encouraged to include a narrative of such under the lease
commitment note to the financial statements.
Scenario 3: If management has decided to continue to occupy the building for a determined lease term,
but no further progress has been made in this regard, the department can calculate the potential lease
commitment based on past practice.

A1.4 Example: Lease of fleet vehicles from the provincial government garage (operating lease)
A provincial department leases its fleet of vehicles from the provincial government garage. It pays the
government garage a daily tariff and a kilometre tariff. The lease is classified as an operating lease.
The payment of the daily tariff (lease instalment) to the government garage will be accounted for as
follows:

Debit Operating lease

Credit Bank account
The kilometre tariff paid to the government garage will be accounted for as follows:

Debit Fleet services: kilometres

Credit Bank account

A1.5 Example: Lease of fleet vehicles from the provincial government garage (finance lease)
A provincial department leases its fleet of vehicles from the provincial government garage. It pays the
government garage a daily tariff and a kilometre tariff. The lease is classified as a finance lease.
The payment of the daily tariff (lease instalment) to the government garage will be accounted for as
follows:

Debit Finance lease – motor vehicles

Credit Bank account
NB: the allocation of the transaction in the infrastructure and asset segment is as follows:
Infrastructure segment: - “Non-infrastructure finance lease capital”
Asset segment: - “Motor vehicle” (an account created under transport assets)
The kilometre tariff paid to the government garage will be accounted for as follows:

Debit Fleet services: kilometres

Credit Bank account

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NB: the allocation of the transaction in the infrastructure and asset segment is as follows:
Infrastructure segment: - “Non-infrastructure (stand-alone) current”
Asset segment: - “Motor vehicle” (an account created under transport assets)

A1.6 Example: Comprehensive example - finance lease (lessee)

Department A entered into a lease agreement on 1 April 20x0 to lease a machine for a period of three
years. The yearly lease payment is R60,000 payable in arrears beginning 30 April 20x0 and the rate
implicit in the lease is 5%. In addition, the department has to pay a contingent rent as an additional
amount due for each copy made over a contractually specified number. Payments made by Department
A over the three years were as follows:

Fixed lease Contingent

payment rent
Year 1 R60 000 R1 240
Year 2 R60 000 R 960
Year 3 R60 000 R1 105
The fair value of the machine is R189,000 and the present value of the minimum lease payments due
is R163,395 (pmt 60,000; i 5%; n 3).
Step 1: Recognise the actual lease payments made by the department during the financial year as
capital expenditure in the statement of financial performance in accordance with the Chapter 8 on
Expenditure. I.e. in year 1, R60 000 is recognised as capital expenditure in the statement of financial
performance.
Recognise the contingent rent as current expenditure in the period payment is made. i.e. R1 240, R960
and R1 105 are recognized in year 1, year 2 and year 3 respectively.
Step 2: Record the lease commitments for the finance lease expenditure in the notes to the financial
statements. This is the future minimum lease payments at financial year end, showing separately those
payable:
• not later than one year;
• later than one year and not later than five years; and
• later than five years.
Extract from Notes to the financial statements
Finance leases expenditure Specialised Land Buildings Machinery Total
military and other and
equipment fixed equipment
structures
20x1 R’000 R’000 R’000 R’000 R’000
Not later than 1 year xx xx xx 60 xxx
Later than 1 year and not later than 5 xx xx xx 60 xxx
years
Later than 5 years xx xx xx xxx xxx
Total lease commitments xxx xxx xxx 120 xxx
At the end of the lease term
Step 3: Determine the amount at which the asset would be recorded in the notes to the financial
statements:

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The MCS states that the leased asset should be recorded at cost, being the fair value of the leased
asset or, if lower, the present value of the minimum lease payments (excluding interest) due.
The fair value is R189,000 (see above).
The present value of the minimum lease payments due is calculated as the sum of the minimum lease
payments made, including any payments made to acquire ownership at the end of the lease term,
excluding interest, which amounts to R163,395, as calculated above.
Step 4: Record asset
The amount to be recorded for the leased asset in the asset register and the financial statements is
R163,395. Once recorded in the asset register, Chapter 11 on Capital Assets is applied in accounting
for the asset.

A1.7 Example: Comprehensive example - operating lease (lessee)

Department Z entered into a lease agreement on 1 April 20x0 to lease equipment for a period of three
years. The monthly lease payment is R2,000 payable in arrears beginning 30 April 20x0. In addition,
the department has to pay a contingent rent as an additional amount due for each copy made over a
contractually specified number.
Payments made by Department Z over the three years were as follows:

Lease Contingent Total

payment rent
Year 1 R24 000 R 240 R24 240
Year 2 R24 000 R270 R24 270
Year 3 R24 000 R110 R24 110

Step 1: Recognise the total lease payments made by the department during the financial year, including
contingent rent, as current expenditure in the statement of financial performance in accordance with
Chapter 8 on Expenditure. I.e. in year 1, R24 240 is recognised as current expenditure in the
statement of financial performance.
Step 2: Record the lease commitments for the operating lease expenditure in the notes to the financial
statements. This is the future minimum lease payments at financial year end, showing separately those
payable:
• not later than one year;
• later than one year and not later than five years; and
• later than five years.
Extract from Notes to the financial statements

Finance leases expenditure Specialised Land Buildings Machinery Total

military and other and
equipment fixed equipment
structures
20x1 R’000 R’000 R’000 R’000 R’000
Not later than 1 year xx xx xx 24 xxx
Later than 1 year and not later than 5 xx xx xx 24 xxx
years
Later than 5 years xx xx xx xxx xxx
Total lease commitments xxx xxx xxx 48 xxx

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 Chapter 13: Leases

At the end of the lease term Unlike finance leases, operating lease asset will not be recorded as the
capital asset of the department.

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